Does the Cyprus Deal Really Herald the End of the Euro?

With the banks in Cyprus not due to reopen until Thursday, after an enforced holiday, it’s too early to reach any definitive judgments on the bailout agreement with the European Union designed to keep the Mediterranean island inside the euro zone and prevent its financial system from collapsing. But that hasn’t prevented some pundits from panning it, and arguing that it could well lead to the demise of the currency zone rather than its rescue. By imposing losses on large depositors in a big Cypriot bank that is to be wound down, the negotiators from the so-called “troika”—the E.U., the International Monetary Fund, and the European Central Bank—have created a time bomb that will eventually explode with disastrous consequences, the critics contend.

Even before the deal had been announced, Darrell Delamaide, a columnist at MarketWatch, pronounced, “[T]here will be lasting effects… that may well have sealed the fate of the Euro.” After the deal was finalized, Alastair Winter, chief economist at Daniel Stewart, an investment bank in London, said it might well come to be seen as the second big step in the demise of the euro. (The first step, according to Winter, whose views made it into a Reuters story, was the recent Italian election, in which voters rejected austerity policies imposed by the E.U.) Wolfgang Münchau, a columnist at the Financial Times, was even more scathing. In a column titled “The break-up of the eurozone edges even closer,” he described senior euro-zone officials as “economically illiterate.”

Maybe the skeptics are right. It’s at least conceivable that when the Cypriot banks open their doors tomorrow, the scene will resemble Pottersville in “It’s a Wonderful Life,” with thousands of ordinary people desperately trying to take out their cash. It’s also possible that the big bank run will come in Spain, or Italy, three or six or twelve months from now, as depositors in those countries come to fear that, in any deal with the E.U., they will receive treatment similar to that meted out to Cyprus in the original bailout agreement, which included a tax of at least seven per cent on all deposits. (In the revised agreements, all deposits worth less than a hundred thousand euros were protected.)

But before you go out and start shorting Spanish bonds and bank stocks, it might be worth considering the fate of previous warnings that the euro was on its last legs. Ever since the debt crisis blew up, in 2010, skeptics on both sides of the Atlantic have been confidently predicting the end of the common currency. In November, 2011, Münchau proclaimed that the leaders of the E.U. had just ten days to save the euro. They didn’t do anything, and the currency survived. On this side of the pond, pessimism about the euro crossed the political spectrum. From the left, Paul Krugman wrote in October, 2011, “it’s looking more and more as if the euro system is doomed.” From the right, Desmond Lachman, of the American Enterprise Institute, said in February, 2012, that the Europeans should abandon “the pretense that the Euro can be saved in its current form.”

Watching the coverage of the crisis unfold has sometimes brought to mind “Dad’s Army,” an old British sitcom about the home guard during the Second World War, wherein Private Frazer, a wild-eyed Scot, wanders around repeating, “We’re doomed. We’re all doomed.” Somehow, though, the euro has survived, and even the skeptics now concede it’s going to be around for a while longer. How can this be? Is the currency zone perhaps more robust than the critics give it credit for?

The bearish argument about the euro is based on some perfectly sound economics. According to the theory of optimal currency areas, which Columbia’s Robert Mundell helped to pioneer, for a common currency to succeed its member countries must enjoy similar business cycles, plus they must have a system of risk-sharing and fiscal transfers to help out less competitive countries during a recession. The euro zone sorely lacks a countercyclical safety net, and, until very recently, it didn’t have any way of pooling financial risks. Ergo, it looked like a good candidate for a breakup—a concern its history has hardly alleviated. In large part, that history consists of a boom and bust cycle followed by a seemingly endless recession, which has been punctuated by contentious bailouts for five member countries: Greece, Ireland, Portugal, Spain, and now Cyprus. (Spain a is a bit of a special case. Thanks to an improvement in the debt markets, the government in Madrid so far hasn’t had to access the funds the E.U. promised.)

The problem with the economic argument is that it is overly reductionist. It fails to take adequate account of politics, and the commitment of the Europeans to preserving the currency zone, if not totally in its current form, at least in its essentials. During the past couple of years, the authorities have endowed Euroland with two things it was sorely lacking: a lender of the last resort in the form of the European Central Bank and a proper bailout fund in the form of the European Stability Mechanism. Although neither organ works perfectly, they are a lot better than nothing, and their very existence defies the predictions of skeptics who said the E.U.’s member states would never ratify a system of institutionalized bailouts. They have done exactly that. Germany reluctantly went along with the E.C.B.’s introduction of emergency lending programs. And twenty-six of the E.U.’s twenty-seven members received parliamentary approval for amending the E.U. treaty to incorporate the stability mechanism. To be sure, the introduction of these reforms, and the forging of the five bailouts, has been a horrendously messy process. But now that it’s been completed, it has considerably lessened the chances of a speculative attack on one country’s bond market bringing down the entire system.

Looking ahead, the biggest threat to the euro is that one country, or a group of countries, might choose to quit the currency zone rather than endure the rigors involved in continued membership. Here too, though, the europhiles have reason for optimism.

If anti-euro fervor were going to take hold anywhere, it would surely have been in the countries that have borne the brunt of the crisis: Greece, Ireland, Portugal, and Spain. But in all four countries, the polls still show solid majorities in favor of staying in the euro zone. To be sure, there are Greeks and Spaniards calling for an end to the euro, just as there are Britons and Germans calling for the same thing, but nowhere have they won the political argument. So far, at least, Cyprus seems to be following a similar path. After the initial demonstrations against the levy on small bank deposits, the public appears to have accepted the revised agreement with the E.U. and the I.M.F. As of yet, there is little evident support for the option of telling the E.U. to get lost, relaunching Cyprus’s own currency, and going it alone.

Of course, that could change. In an interview earlier in the week, Christopher Pissarides, a Nobel-winning economist who heads Cyprus’s economic policy council, raised the prospect of a radical shift in direction. “[O]nce the dust settles down… we should sit down and think very carefully on whether, in future, it is better to be within the eurozone or without,” Pissarides said. “I also recommend that all small countries in particular and do their homework. Because as we have seen if you get in trouble, you are not necessarily going to be rescued in a way that benefits your economy.”

But even if Cyprus did decide to go it alone, and Greece followed its example, say, would such a dramatic development spark a breakup of the euro zone as a whole? Not necessarily. Now that they have a system in place to deal with any contagion, the authorities in Brussels, Frankfurt, and Berlin appear to be pretty relaxed about the prospect of one or more peripheral countries splitting off. If Europe’s paymasters had really believed that the Cypriots (or the Greeks) had the capacity to bring down the entire system, they surely wouldn’t have taken such a tough line with them in the bailout negotiations.

Italy and Spain, as the fourth and fifth largest economies in the E.U., are in a completely different category, of course. If either, or both, were to blow up and crash out of the euro, the common currency would be destroyed—or reduced to an Anglo-Saxon core. But has the Cyprus bailout really made such a prospect more likely? If as Jeroen Dijsellbloem, the Dutch finance minister, initially suggested, it was intended to serve as a template for future bailouts, then it could, indeed, have served to hasten bank runs in places like Spain and Italy. But too much has been made of Dijsellbloem’s statement, which he subsequently disavowed. He is, after all, from Holland, hardly a European powerhouse.

During each set of bailout negotiations, the ultimate authorities—Angela Merkel, the German chancellor; Mario Draghi, the E.C.B. chairman; and Christine Lagarde, the head of the I.M.F.—have acted pragmatically, insisting on the toughest terms they could extract short of inspiring an insurrection in the country concerned or an outbreak of contagion. Because of the peculiar capital structure of the Cypriot banks, hitting big depositors—mostly Russians—was the only way to extract a significant contribution toward the cost of the bailout from the banks’ stakeholders. Spanish banks, say, are very different animals, with far fewer offshore depositors. Given that fact and the strategic importance of the Spanish economy, the troika would surely treat them much more gingerly than they treated their counterparts in Athens and Nicosia.

At this moment, the biggest threat to the euro comes not from the Cyprus bailout but from the prospect of its biggest members, particularly Germany, sticking with misguided austerity policies. (This is something Krugman has rightly stressed.) In Greece and Spain, the unemployment rate is stuck above twenty-five per cent. In Ireland, Italy, and Portugal, it is well into double figures. Large swaths of the European economy are slowly rotting away. As I noted the other day, no democratic political arrangement can survive an indefinite economic slump. If measures aren’t taken pretty soon to revive spending and hiring, xenophobic anti-Brussels parties will eventually gain popular support in some (perhaps many) countries. And, meanwhile, the soured loans resulting from the slump will continue to undermine the continent’s banks.

But such an outcome isn’t inevitable. Strictly as a matter of economics, there is nothing to prevent a policy of reflation being adopted. Indeed, part of such a program—monetary expansion and a devaluation of the currency—is already in place. If this plank were to be combined with a coördinated fiscal expansion, led by Germany, the European economy would start to grow again, and the financial crises in places such as Spain and Italy would recede. So far, Merkel, who faces parliamentary elections later this year, has resisted such a shift. But as the Euroland recession starts to bite at home as well as abroad—in the latest quarter, the mighty German economy contracted—the development of German thinking bears watching.

Having imposed tough bailout terms on the heavily indebted peripheral countries, the German chancellor is in a much stronger position to argue to her voters that a policy of reflation wouldn’t merely be rewarding the irresponsible, it would also be in Germany’s interest. Such a change of tack would surprise many people, but it wouldn’t be completely out of character. At the crucial moments in saving the euro—expanding the remit of the E.C.B., setting up the new bailout fund, revising the terms of the Greek bailout—Merkel and her German colleagues have done what is necessary, or, at least, they have acceded to others doing it.

Unlike the euro pessimists, I wouldn’t be wholly surprised to see something similar happen again. The history of the common currency follows a pattern. Just when you think it is about to collapse, they find a way to keep it going.